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Section 404 of the Sarbanes-Oxley Act requires companies to disclose internal-control deficiencies in their annual reports. The effects on share prices are examined in “Control Deficiencies: Finding Financial Impurities,” a new analysis of 2004 and early 2005 disclosures by shareholder-advisory firm Glass, Lewis & Co.

Glass Lewis examined companies with a market capitalization in excess of $75 million. About 11 percent of these companies disclosed a control deficiency between January 1, 2004, and May 2, 2005. The number of companies that disclosed a material weakness — the most severe control problem — totaled 586 for the first four months of 2005, compared with 313 for all of 2004, according to the report.

On average, the day after a company disclosed a material weakness in its financial controls, its share price dropped 0.67 percent relative to market movement, Glass Lewis found. After 7 days, the share price dropped 0.90 percent; after 30 days, 1.96 percent; and after 60 days, 4.06 percent. “The mere announcement of a material weakness, independent of the auditor opinion, appears to solicit a negative reaction from investors,” according to the study.

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Average Share Price Movement,
Relative to Market, vs. Seven Days before Announcement

1 day after

7 days after

30 days after

60 days after

All Deficiencies

-0.72%

-0.81%

-1.50%

-3.02%

Material Weaknesses

-0.67%

-0.90%

-1.96%

-4.06%

Qualified Opinions

-0.23%

-0.66%

-2.30%

-3.56%

Qualified Opinions,
No Warning

-0.04%

-0.16%

-2.49%

-3.94%

Sources: Glass Lewis, FactSet.

Revelations of material weaknesses related to personnel issues seemed to raise the greatest concerns among investors, the report also found. On average, the day after a company disclosed such an issue, its share price dropped 0.92 percent relative to market movement; after 7 days, the share price dropped 1.19 percent; after 30 days, 2.31 percent; and after 60 days, 4.80 percent. Although material weaknesses related to documentation or tax-accounting issues were not punished as immediately by the market, after 60 days companies disclosing such weaknesses suffered an even greater loss in share than companies with personnel issues, the report found.

Average Share Price Movement by Category,
Relative to Market, vs. Seven Days before Announcement

1 day after

7 days after

30 days after

60 days after

Financial Systems and Procedures

-0.34%

-0.71%

-1.35%

-3.75%

Personnel Issues

-0.92%

-1.19%

-2.31%

-4.80%

Documentation

0.14%

0.12%

-0.41%

-5.29%

Revenue Recognition

1.04%

0.12%

-0.41%

-5.29%

Lease Accounting

-1.39%

-0.71%

-0.13%

-0.86%

Tax Accounting

-0.27%

-1.20%

-4.22%

-5.77%

Other

-2.59%

-2.15%

-0.06%

-3.31%

Sources: Glass Lewis, FactSet.

Not surprisingly, companies that disclosed a material weakness were treated more kindly by the market if they filed their annual reports on time. On average, the day after an on-time disclosure, company share prices dropped 0.31 percent relative to market movement; after 7 days, 0.85 percent; after 30 days, 2.91 percent; and after 60 days, 4.12 percent. Even “using the 15-day or 45-day extension didn’t seem to bother investors as much,” Glass Lewis found.

And as for late filers? Companies that let their deadline pass “without filing a management report or auditor opinion on the effectiveness of internal controls,” the study found, saw their share prices drop an average of 2.13 percent after one day; after 7 days, 2.89 percent; after 30 days, 3.81 percent; and after 60 days, 7.01 percent.

Average Share Price Movement by Filing Time,
Relative to Market, vs. Seven Days before Announcement

Filing Time of 10-K

1 day after

7 days after

30 days after

60 days after

On Time

-0.31%

-0.85%

-2.91%

-4.12%

15-Day Extension

0.14%

-0.45%

-0.30%

-2.67%

45-Day Extension

-0.95%

0.04%

-2.43%

-3.28%

Late Filer

-2.13

-2.89%

-3.81%

-7.01%

Sources: Glass Lewis, FactSet.

Glass Lewis observes that as investors spend time vetting the facts and figures accompanying disclosures of control deficiencies — that is, as the underlying reasons “sink in” during the first 7, or 30, or 60 days — some of them invariably sell off stock of the company in question.

That’s not true for everyone, however. Michael Crofton, president and chief executive officer of The Philadelphia Trust Co., which manages $1.5 billion in assets for institutional and individual investors, says he uses deficiency disclosures to help identify buying opportunities.

Irrational market reactions, such as temporary stock dips caused by material-weakness disclosures, can be “opportunistic points of entry,” says Crofton. Many of these reactions, he contends, are due to stock dumping by hedge funds, performance-driven mutual funds, or other investors overly concerned with near-term gains. If Philadelphia Trust’s analysis indicates that a company is fundamentally sound, adds Crofton, during the dips he’ll snatch up shares that may have been too expensive at pre-disclosure prices.

Neri Bukspan suggests thinking of material-weakness disclosures as computer-virus warnings. Bukspan, the chief accountant at Standard & Poor’s, observes that the discovery of a virus is always worrisome, but how to proceed is even more important. Does the “virus” — that is, the material weakness — warrant a “complete system overhaul,” or has the problem been identified, quarantined, and fixed?

Of all the S&P-rated companies that disclosed a material weakness, notes Bukspan, fewer than 10 percent were downgraded, added to RatingsWatch, or given a negative outlook. He says that’s because many control deficiencies are not systemic or indicative of broader accounting or reporting problems, and they don’t hinder a company’s ability to issue accurate, timely reports that can be relied on to assess financial health.

The S&P chief accountant does acknowledge that disclosures of material weaknesses can be a “circular exercise”; it’s common for the discovery of one problem to lead to others. Such disclosures also bring to mind the “chicken and the egg puzzle,” he adds. That is, it’s often difficult to tell whether the material weakness is the cause or the effect of more-serious problems, including restatements, accounting scandals, and ineffective management.

The bond and stock markets seem to be reacting judiciously to news of material weaknesses, observes Bukspan. He points to a March study by S&P that assessed the bond market’s reaction to material-weakness disclosures by financial-service companies; the study found no discernable change in rates.

Even when the market does not react to material weaknesses, says Bukspan, the disclosures “allow investors to sort out the consequences.” But Section 404 requirements are even less familiar to investors than they are to companies, he adds. It may be two or three years until the markets have sufficient experience with Sarbanes-Oxley disclosures — and until analysts can make a definitive statement about the effects of material weaknesses on share price.